Why securities lending adds value to your portfolio
With markets bringing in significantly reduced returns over the last couple of years, pension funds have been put under pressure to maintain their performance in order to fulfil future pension obligations. In the light of this subject, the word that passes most lips and hands is the ‘coverage-ratio’. According to the Financieel Toet-singskader (FTK) that will be in place by January 2006, pension funds have to comply with strict coverage ratios to avoid future under-funding.
The discussion has persuaded the industry into a wider search on alternative routes to keep in line with required solvency ratios. Securities lending can be an interesting tool for pension funds to add value to the portfolio
without increasing risk.
What is Securities Lending?
Securities lending is the activity where a lender lends out (part of) its shares or bonds from its investment portfolio to a party that has a temporary need for these securities. Although the legal ownership (voting right) is being transferred from the lender to the borrower, the lender still remains the economical owner of the securities
(market risk, dividends), receives collateral and gets paid a rebate (fee) for doing this transaction. During the loan process, legal entitlements such as dividends, rights, bonus issues and voluntary corporate actions pass to the borrower. The lender is compensated by the borrower for the loss of the additional income during the lending period, for instance by paying a compensation fee for
The lender always has the right to recall the borrowed securities and consequently, securities lending does not hinder asset managers from actively managing their
The activity is regulated through a different set of contracts, which are being exchanged and signed between the borrower and lender. The most common contracts are the OSLA (Overseas securities Lending Agreement), and more currently, the GMSLA (Global Master Securities Lending Agreement).
The main type of lenders are pension funds, insurance companies, banks, asset managers and investment companies because of their often stable investment of assets. The borrowers can be clearing organizations, banks,
trading desks and hedge funds.
Securities Lending, oil of the financial markets
While securities lending today forms the oil that makes the financial market machine run, the practice initially developed by trading houses to reduce costs, specifically the costs associated with failed deliveries. Nowadays, securities lending is the link between the derivatives market and the stock exchange. No call or put option can be traded without having a lending facility.
Some investors were anxious about the effects of
Securities Lending and Borrowing on the prices of the stock markets. However, the UK regulatory authority,
the FSA, stated in a study in the latter half of 2002 that securities lending played a vital part in an efficient working market as did short selling, which provides price
discovery, liquidity and narrowing down bid-offer spreads. The FSA deemed the activities as normal market activities and felt that sufficient regulations were in place to discourage abusive trading strategies and discipline those found guilty.
Risks of securities lending for pension funds
The risks of Securities Lending for Pension Funds are clear. When looking at pension funds, three main risks can be identified: counterparty credit risk, collateral risk and operational risk.
Counterparty credit risk, the risk on the borrower, has to be managed by setting limits and constraints toward the minimum rating of a borrower. Collateral risk, the risk that the collateral received by the lender, becomes untradable, and therefore worthless, is quite often dealt with by demanding high liquid, highly rated (AA+ or better) government bonds as collateral. Collateral is calculated by default as 105% of the actual loan value, therefore creating a margin of 5% to be maintained throughout the term of the transaction. The operational risk can best be described as daylight risk, the risk of settlement failures and therefore creating intraday exposures. The most common way of taking care of this issue is by
having collateral settle before releasing delivery instruction on the loaned
securities. This practice is very common in the USA, where collateral settles even one day prior to receiving borrowed securities. Securities Lending don’t comprise market risk, as the lender remains the economic owner of the stock.
Extent of Revenue and Fees
The easiest way to answer this question is to look at the many magazines and workshops, request for proposals, sales efforts and presentations that are being conducted. Multiplied with at least five times, it gives a suggestion of the outcome and impact that securities lending can have on the (cost) budget and performance of pension funds.
Revenue generated is dependant on the tax status of the fund, the asset allocation, the size of the fund and the portfolio management strategies employed, whether active, passive or mixed strategy. All of these factors play an important part in desirability of a portfolio and the potential fees generated by securities lending. Roughly, revenue generated could average 10-50 basis points. Fees can be guaranteed for a year and paid on a monthly basis to the pension fund.
Methods to lend the portfolio
The question how and in what way to participate, keeps most conferences on this subject well attended throughout the year. Clearly, the way to participate depends on size, profile, regulatory environment and internal, political characteristics of the pension fund. Three main methods can be summed up:
1. Principal lending: the pension fund gets involved on a principle basis, having its own lending desk, managing collateral, risk, operations and sales.
2. Agency lending: pension fund selects one (or more) agents to take care of lending their portfolio, splitting the revenue with the agent, who in most cases will be the global custodian. The combination of custody and securities lending at one provider reduces the administrative burden and is therefore a good solution for medium sized pension funds.
3. Market auctions. The pension fund puts its portfolios up for auction, whereby a selected agent takes care of the operational duties, but the decision making process remains with the pension fund. Electronic auction platforms have become a preferred method of lending with some of the world’s largest pension funds such as CALPERS and ABP. This method provides more lending channels and portfolios are lent in their entirety to the highest bidder. Securities lending administration is carried out by the third party lending specialist and in some cases, the custodian retains management of the day to day securities lending and management.
Added value for pension funds?
In summary, Securities Lending can add additional income to portfolios within the boundaries of acceptable risk. It reduces the overall cost budget and adds performance.
It is increasingly import that pension funds understand the importance of their role within the Securities Lending market, in adding liquidity and enhancing portfolio returns. In order to foster relationships between the Pension Fund Management market and Securities Lending market, Fortis Bank is organising workshops relating to Securities Lending and Borrowing, the inherent risks and returns for Dutch Pension Funds Trustees and Directors. Upcoming workshops will be held on the 2 November and the 15 December at Fortis Bank in Amsterdam.
If you have any questions or would like to attend the workshops which we have scheduled, please contact:
Wouter van der Ploeg
Director, Amsterdam, The Netherlands: 020-527 1637
Director, Amsterdam, The Netherlands: 020-527 1457
Relationship Manager, London, UK,
+44 207 444 8285